U.S. Secretary of Treasury Henry Paulson (L) stands next to Federal Reserve Chairman Ben Bernanke (R) during a briefing to the media about financial markets and the Market Stability Initiative, in the Cash Room of the Treasury Department in Washington, October 14, 2008. REUTERS/Larry Downing (UNITED STATES)

Photo: Larry Downing, Reuters

U.S. Secretary of Treasury Henry Paulson (L) stands next to Federal...

It took 10 days, a stock market crash and a push by the British, but Treasury Secretary Henry Paulson managed Tuesday to do what economists of all persuasions and congressional Democrats had been urging for weeks: infuse $250 billion directly into U.S. banks to unfreeze credit markets and forestall what had promised to be an economic contraction of historic proportions.

And so it is that a Republican administration and a former chief executive of that temple of risk-based capitalism, Goldman Sachs, will preside over a partial nationalization of U.S. banks. It will be on a scale not seen since Democratic President Franklin Roosevelt's New Deal, which is considered the birth of the modern interventionist state.

"We regret having to take these actions," Paulson said in the aptly named Cash Room at the Treasury. "Government owning a stake in any private U.S. company is objectionable to most Americans, me included, yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable."

The latest moves by the Treasury Department, coordinated with the European Union and Japan, are an emergency move to restore confidence and induce banks lend to again. The new approach does not guarantee that financial storms are over, economists said, or that the incipient recession will be mild. The severe financial shocks already have contracted some lending to consumers and businesses. And more rescues or failures of financial institutions could be in store.

Will it work?

"About 10 things have to go right to escape with a mild global recession," said Simon Johnson, an economist at the Massachusetts Institute of Technology and former assistant director of research at the International Monetary Fund who runs the Web site baselinescenario.com. "We think the U.S. and the world are heading into a pretty severe global recession. Whether it gets worse or not remains in question."

The $250 billion comes from the first installment of the $700 billion rescue that Congress passed Oct. 3.

The Treasury Department hopes the fresh capital will thaw lending among banks. Whether banks then resume lending to consumers and businesses is the next question, said Darrell Duffie, a finance professor at Stanford University.

"It's quite possible there are still weaknesses in the financial system that will come to light," Duffie said. "We don't know what financial institutions are teetering and whether this injection of capital will be enough to keep them from going over the edge." He said overvalued commercial real estate loans could become the next area of vulnerability.

Version two of the Paulson plan means that U.S. taxpayers will buy preferred shares in nine big banks within the next few days, and, by year's end, a raft of community banks. The government will receive dividends of 5 percent for five years and 9 percent after that if the banks do not repay by then. The government also will receive warrants allowing the purchase of as much as 15 percent of the original investment in common stock.

The plan, coordinated with the EU and Japan, also extends temporary federal insurance on certain types of bank debt and deposits.

Investor Warren Buffet got a much sweeter deal with his $5 billion loan to Goldman Sachs (10 percent dividends and warrants for another $5 billion in common stock), but the government loans come with strings limiting executive pay and dividends.

Congressional leaders insisted on including authority for direct capital infusions despite Paulson's fierce resistance to the idea. Treasury officials said they will proceed on a parallel track with Paulson's original plan to buy up troubled mortgage-backed assets, a cumbersome and indirect way to aid bank solvency that has been widely panned. More damning was last week's market verdict: Credit markets remained frozen, and stock markets plummeted worldwide.

Bush signs request

President Bush issued the written request Tuesday as the law requires for the second installment of $100 billion.

Some think the original Paulson plan should be junked entirely.

"They did a good job doing a double back flip, triple axel, about-face over the weekend on bank recapitalization," MIT's Johnson said. "They could save that remaining $450 billion for a war chest, because a recession could get sufficiently severe that there will be more losses in financial institutions that you'll have to recapitalize again."

The problem with buying toxic mortgage-based assets is that while it provides liquidity to banks, it does nothing to slake their thirst for new capital to lend. The Federal Reserve was already pumping liquidity into banks to little avail.

Banks lend anywhere from $10 to $15 for every dollar of assets they hold, and investment banks go even higher, said Pete Kyle, a finance professor at the University of Maryland who served on the Brady Commission that investigated the 1987 stock market crash. That means that for every dollar banks lost on mortgage-backed securities Kyle said, "they were trying to reduce their balance sheets by $10, $15 or more," a breathtaking contraction in bank lending.

Injecting money directly into banks stops that process and allows the banks to start lending again, putting money back into the economy at that 10-to-1 or higher ratio.

The multiplier effect

Buying the bad assets misses out on that multiplier effect. It also bails out everyone who bought bad mortgage assets, including hedge funds. And if the government underpays for the assets, it makes a bank's problems worse. Yet if it overpays, taxpayers get bilked.

"You could have played with the price and overpaid for the assets, and that in effect would have provided more capital," said Gerald O'Driscoll, a former vice president at the Federal Reserve Bank of Dallas now at the libertarian Cato Institute. "It would have been a back-door, and I would say corrupt, way of recapitalizing the banks. The way you address a capital problem is you provide capital."

Paulson signed on very late to that idea.

"Hank Paulson's a conservative Republican," said UC Berkeley economist Brad DeLong. "He is not comfortable living in sin with the banks. He believes in private where private belongs and public where public belongs, and public should be small and government should be supervising and setting up markets and not sticking its nose into everything. He believes that's a recipe for corruption and inefficiency and political pressure and ultimately for disaster."

Still, most analysts think the new plan has a much better chance, because it is "finally addressing the problem," said former Fed official O'Driscoll. Still, he cautioned that in his experience, banking crises usually wind up costing about "twice as much as whatever they first say."